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Are ETFs beating out mutual funds in popularity?

Maybe, but there are clouds on the sunny ETF horizon

While mutual funds will continue to coexist with exchange-traded funds, growth of ETFs has far surpassed the older industry since the financial crisis of 2008-2009, experts told the Exchange Traded Forum 2016 in Toronto this week.

In a keynote talk, Dave Nadig, ETF director for FactSet Research Systems Inc. of Norwalk, CT, said that since the financial crisis, “all the assets are effectively flowing into ETFs, most of them to Vanguard.” Over that time, net mutual fund inflows were US$61 billion, compared to a whopping US$1.2 trillion for ETFs.

The growth rate for ETFs on both sides of the border resembles the classic hockey stick curve, and is just starting in Canada, Nadig said. “It’s the classic standard adoption model and has just ticked right along every year except 2008. It’s right on target. This tells us we will have a US$22 trillion market by 2024, surpassing the global retail mutual fund business.”

Why? The ETF industry is hitting on all major cylinders for global adoption. It’s the right product for new money, Nadig said, making it increasingly the choice of the millennial generation. “There’s not a lot of growth poaching 70-year-olds’ accounts.”

One recent U.S. survey found that for the first time, 81% of financial advisors were recommending ETFs, surpassing mutual funds for the first time ever. “Indexing is winning and people just realize it more and more.”

Still, there are clouds on this seemingly sunny ETF landscape, some of which could start to appear later this year, Nadig warned. The sheer popularity of ETFs is making regulators nervous, especially about the more controversial leveraged and inverse ETFs that are often popular with hedge funds and sophisticated institutional investors.

Nadig said double-long leveraged ETFs will probably continue to exist (these produce twice the returns than a normal long ETF in rising markets, but amplify losses in declining markets). However, he believes reverse double long products may be retrenched to a reverse leverage factor of just 1.5 times. Triple long and triple inverse ETFs could disappear completely, he warned, although “Only hedge funds will lose sleep over this.”

Senior Bloomberg ETF analyst Eric Balchunas presented ten “mind-blowing” ETF statistics, the first of which was that the dollar volume of ETF trades in the U.S. each year is US$19 trillion, surpassing the US$18 trillion American gross domestic product. But the rise of passive investing has also meant a 70% cut in revenue for the financial industry as a whole, since “active funds produce much higher fees.”

As the trend cuts into the traditional active management business, “the financial industry is having its Napster moment,” Balchunas said, making an analogy to how free music file-sharing savaged the music industry. Another supposedly mind-blowing fact is that “The top five largest funds in the world are all passive.” Four are from the Vanguard Group, the other is the SPDR S&P500 ETF Trust.

This revenue decline is “a bit scary,” he said, but the rapidly growing pie is masking the drop in overall revenue. The industry is now launching four new ETF products every day: 1,004 were released worldwide last year over the course of 250 business days. So-called “Smart beta” products accounted for more than half of those launches and now account for more than 20% of industry assets.

Another problem is that as these products become more complicated they require more due diligence. An entire panel session on the second day of the conference was devoted to the rise of ETF strategists that a growing number of advisers are now using.

National Bank Financial ETF research head Daniel Strauss told the audience on the second day that “there’s no sign of the industry plateauing.” The Canadian ETF market has grown from three funds and $6.6 billion in assets 15 years ago to 428 funds and $95 billion today, an annual growth rate of 20%. The U.S. now has 1,866 ETFs holding US$2.2 trillion.

Even so, Strauss said he doesn’t believe ETFs are eating the lunch of the mutual fund industry. “The mutual fund industry is still growing at a rapid clip,” with a 10 year compounded growth rate of 7%.

If anything, the two industries may be converging, as we see mutual fund wraps using ETFs as the underlying investments and of course we are also seeing some mutual fund companies hedging their bets by buying into some ETF manufacturers.

If you can’t beat them, join them!

Jonathan Chevreau is the founder of the Financial Independence Hub and can be reached at jonathan@findependencehub.com

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